Monday, February 5, 2018

The Mechanics of The Seloff -- And -- Expect More Of The Same For Awhile Longer

Yes, we've been preaching herein that volatility is coming, and that, in light of the extreme lack thereof for a record period of time, it was likely going to be uncomfortable at best. And while we're very much within the % range of your garden variety correction, the speed in which we got to this point, I must confess, I find remarkable.

Strangely, this could indeed be the market reacting to too much good news all at once. We warned of that risk back on December 1st in a blog post we titled Tax Reform and Its Economic Implications. Here's a snippet:

You see, the U.S. economy is actually doing quite well at the moment, while the jobs market is as healthy as it's ever been -- and, friends, that's not open for debate. Therefore, a tax plan whose title encompasses economic and jobs growth at a time when both are firing on most cylinders conjures up images of a pulling forward of economic activity (that would've occurred over a longer period), rising inflation, higher interest rates and so on.

And, yes, a lot of the talk this past week has been about stocks reacting to the prospects for inflation and higher interest rates going forward.But this much of a reaction, this quickly, amid such a favorable economic backdrop with still low inflation and historically low interest rates??

My sense is that the precipitous nature of the selloff has more to do with something we pointed out in this morning's first blogpost, albeit something sparked by the threat of higher interest rates:

"...the mechanics of certain institutional investment strategies will force the unwinding of positions, likely exacerbating Friday's selloff early in the week."

Well, clearly, the selloff that began last week was exacerbated by something today. And my best guess is that it ain't over just yet. Excerpts from a Bloomberg commentary this evening support the unwinding of specific, mechanical (quant) strategies theory:

"Philip Blancato, CEO of Ladenburg Thalmann Asset Management in New York. 'Today was a classic risk-off day when so much of the selling is going to be program trades based on technicals. It cleans up some of the people who are on the fence. You got the irrational exuberance out of the market.'"

Although I think Mr. Blancato may be a little premature with his statement "You got the irrational exuberance out of the market." Again, it wouldn't surprise me to see more of the same for a bit longer.

The rest offers more support for the systematic trading excuse, and points to a similar time in 2011 (when the macro setup was bullish, as it is today). The last paragraph makes sense to me; which is consistent with our eagle analogy and the present signals from the macro data:

A few analysts used the term “flash crash” to describe the events, a loose term that denotes everything from exchange malfunction to harmonized selling by quant funds. “Millions of quant orders went in one direction, and it overwhelmed a lot of these breakers. That’s it,” said Dennis Debusschere, head of portfolio strategy at Evercore ISI, said by phone from New York. “It was very quant, very systematic.”

A group that may be suffering the most is anyone who is shorting volatility, a trade that amid two years of market tranquility has been a route to some of the easiest money on Wall Street. As markets buckled, the Cboe Volatility Index surged 124 percent to 38.8. It closed at 37.32, still up 115.6 percent.

That said, today’s selloff isn’t completely unprecedented, particularly in comparison to the period during and after the financial crisis. For four days in August 2011 the Dow alternated up and down days of 4 percent and 5 percent, and it tumbled as much as 6.6 percent on Aug. 24, 2015. Those days were quickly forgotten as the bull market picked up steam.

“I don’t sense a whole lot of panic,” Doug Ramsey, chief investment officer at Leuthold Group LLC, said by phone. “Just 10 days ago momentum was at the highest level in the S&P history and it would be very unusual it the stocks made a final bull high when the momentum was that strong. I’m not sure this is the end of the adjustment, but the odds are in favor of the market stabilizing here in the short-term and trying to push to a higher high.”